The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Thursday, May 30, 2013

Why Shareholder Rescue Never Comes to end Too Big to Fail Banks

In his ProPublica article, Jesse Eisinger looks at why shareholders don't end the problem of Too Big to Fail banks.

Mr. Eisinger had hoped that shareholders would put pressure on bank management because of low share prices to break up these institutions.

He considered the possibility that because of opacity, shareholders were worried about how the risk would be distributed if they forced a break-up. So this restrained the shareholders forcing a break-up.

Then, leaving opacity behind, he settled on the idea that shareholders actually prefer banks to take on risk as they have capped downside and unlimited upside.

Mr. Eisinger is on the right track. However, he failed to see the link between opacity and the type of shareholders that banks attract.

As regular readers know, under the FDR Framework, there is a three step investment process:

Investor independently assesses all the useful, relevant information to determine the risk of and value of the investment;

Investor solicits bids from Wall Street to buy or sell the investment.

Investor compares the price shown by Wall Street to independent valuation to make buy, hold or sell decision.

When there is opacity, as is the case with banks, investors do not have access to all the useful, relevant information and therefore they cannot independently assess the risk or value the investment. As a result, investors cannot go through the investment process.

So buying or selling shares in a bank is not investing, but rather something else entirely.

As the Bank of England's Andrew Haldane says, banks are "black boxes". Nobody other than the bank regulators knows what risks are inside these boxes. This has important implications for the types of shareholders that banks attract.

Investors are not attracted to banks because investors cannot go through the investment process. They recognize that buying or selling bank shares is nothing more than gambling on the contents of a black box.

Naturally, the shareholders who are attracted to the big banks are not investors who would exert discipline on management, but rather gamblers. By definition, these gamblers want bank management to take on risk because as Mr. Eisinger noted their downside is capped and their upside is unlimited.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.